To Defer (Taxes) or not to defer? That is the question.
by Steve Gail
I have been asked on so many occasions, is it better to pay taxes on your investments year after year until you retire or have your taxes in a tax deferred account where you pay your taxes at the end either on a lump sum distribution or on periodic withdrawals.
Today, we will attempt to put to rest once and for all this question that tends to reoccur as much as the common cold.
To begin with, certain assumptions regarding tax rates have to be assumed at the beginning and ending of the accumulation and distribution period. (DRIP investors should especially take note, as this could be an important decision as to whether starting a DRIP plan in a ROTH IRA is advantageous or not.) Unfortunately, my article can not cover all the infinite number combinations of tax rate scenarios that could happen over a 20 - 30 year period.
However, we can take the best and worse case scenarios at each tax rate extreme. In other words, we can examine a comparison between a low tax rate environment in the accumulation and distribution period then compare that with an extremely high tax rate environment for the accumulation and distribution period, over the same time. In addition, we can also see how rates of return will effect our scenarios.
After examining the chart below, you will be able to draw several firm conclusions regarding the Tax-deferred vs. the taxable comparison issue, once and for all.
For the sake of simplicity the following chart will compare an investment of $1000 in a tax-deferred and a taxable account, with three (3) various tax rates (10%, 30% and 50%), with four (3) varying rates of return (4%, 8%, 12% and 20%) and see how the deferred and taxable accounts compare. After these examples, you will have no doubt.
EXHIBIT A: (Below)
As you can easily see from the chart above, we can conclude unequivocally the following:
1. No matter how high the tax rates, a tax deferred account will ALWAYS net higher returns compared to an IDENTICALLY invested account where taxes are paid, on going every year.
2. The Difference between the tax deferred account and the taxable account will FURTHER be impacted if the RATE OF RETURN is higher. (e.g. see the 20% return)
I could run scenarios for hours, but I think you can see clearly that any opportunity that you have to defer taxes will be advantageous, no matter what the tax rates will be in the future.
In terms of net dollars, there is no contest. I hope that DRIP investors take this into consideration when they consider a DRIP program, especially if you do not currently have a ROTH IRA investment. Again, something to consider.
Until Next Time,